Executive Comp Excise Tax Rules Sweep Too Broadly, Firm Says

May 10, 2019

CC:PA:LPD:PR
Notice 2019-09
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on Guidance Under Section 4960 of the Internal Revenue Code Regarding Tax Imposed on Excess Executive Compensation Paid by Tax-Exempt Organizations

Ladies and Gentlemen:

Covington & Burling LLP is pleased to respond to the request for comments by the U.S. Department of the Treasury and the Internal Revenue Service (collectively, the “Agencies”) in Notice 2019-9 (the “Notice”). The Notice provides interim guidance on the tax under Internal Revenue Code § 4960¹ that is imposed on applicable tax-exempt organizations (“ATEOs”) and related entities with respect to certain executive compensation paid by those ATEOs and related entities. The Agencies have indicated in the Notice that they intend to issue proposed regulations under § 4960 and have requested comments on the topics addressed in the Notice and on any other issues under § 4960. We welcome the Agencies' efforts to provide regulatory guidance to employers seeking to understand and comply with the requirements of § 4960. This comment letter focuses on the treatment of compensation paid by for-profit entities to their employees who also provide limited services to related ATEOs, where the ATEOs compensate neither the related for-profit entities nor the employees for these limited services.

Summary of Comments

The Agencies have recognized that compensation paid by a for-profit entity to its employees who perform volunteer services for a related ATEO raises questions of interpretation under § 4960 that are not resolved by the statutory language. An overly broad reading of the statute — and in particular an interpretation that would sweep in all compensation paid by for-profit entities to employees who perform any services for related ATEOs — could hinder rather than promote the appropriate and efficient use of charitable and other exempt-function resources and cause adverse consequences not intended by Congress when it enacted § 4960. Accordingly, we respectfully suggest that the proposed regulations adopt one of the following approaches to this issue:

• Safe harbor. Provide a safe harbor definition of “employee” that is based on the existing volunteer exception to the Form 990 reporting requirement. Under the safe harbor, an employee of a for-profit entity would not be treated as an employee of a related ATEO for § 4960 purposes, and compensation paid to the employee by the for-profit entity would not be taken into account for § 4960 purposes, if (1) the ATEO does not control the for-profit entity, (2) the for-profit entity does not provide management services for a fee to the ATEO, and (3) the employee provides only volunteer services to the ATEO, i.e., services for which the ATEO pays no compensation to the employee.

• Allocation of compensation. Define compensation paid by an ATEO for § 4960 purposes as compensation for services performed as a common law employee of the ATEO — whether paid by the ATEO or by a related organization — and provide guidance on how the services are to be allocated between the ATEO and the related organization for these purposes.

Both of these approaches are consistent with the language of the statute and its intent — i.e., ensuring that the limited financial resources of tax-exempt organizations will be used for exempt activities while preventing avoidance of the tax by substituting a related organization for the tax-exempt organization as the entity paying the compensation.

Background

The Tax Cuts and Jobs Act of 2017 (the “Act”)² added § 4960 to the Internal Revenue Code. Section 4960 imposes on employers an excise tax at the corporate income tax rate (currently 21 percent) on (1) remuneration in excess of $1 million paid to a covered employee by an ATEO or a related organization, and (2) certain excessive separation pay. The legislative history of the Act indicates that § 4960 was intended to (1) discourage diversion of resources from exempt activities to payment of excessive executive compensation, and (2) align the tax treatment of excessive executive compensation paid by for-profit and tax-exempt organizations by imposing on ATEOs rules similar to §§ 162(m) and 280G.³

As the Notice recognizes, the issues regarding compensation paid by related organizations arise in this context:

• Many for-profit entities establish and control related tax-exempt organizations. Employees of these for-profit entities often serve as directors or officers of the related tax-exempt organization on a volunteer basis.

• Frequently, there is no common law employment relationship between the volunteer and the ATEO. In fact, it is typical for a volunteer officer not to be controlled by the board of the tax-exempt organization in a manner that would render the officer a common law employee of the tax-exempt organization.⁴

• Thus, it is not uncommon for a volunteer officer to serve a tax-exempt organization as an independent contractor — i.e., the volunteer officer is accountable to the organization's board of directors, but the board does not control how or when the officer carries out his or her prescribed duties and does not direct how the officer accomplishes those duties on a day-to-day basis.

• The volunteer officer is usually a common law employee of the related for-profit entity, and operates under the direction and control of the for-profit entity. In fact, it is typical for donors, including for-profit entities that establish and control related ATEOs, to ask their employees to serve as officers of the tax-exempt organizations, to ensure that the tax-exempt organizations use donated funds for exempt purposes.

• Neither of the legislative purposes motivating enactment of § 4960 is served by imposing the excise tax on compensation paid by for-profit entities to their employees who are not common law employees of the ATEO.

• Accordingly, the Notice indicates that compensation paid by a for-profit entity to an employee who is providing services to a related ATEO as a volunteer will not be taken into account for purposes of § 4960 if the volunteer, including a volunteer officer, is not (and has never been) a common law employee of the ATEO.⁵

Notwithstanding this conclusion, which we believe is the correct one, the complexity and uncertainty inherent in determining whether a common law employment relationship exists — and thus the uncertainty regarding whether the § 4960 tax might apply — would likely discourage for-profit entities from permitting any relationship between their employees and related ATEOs. Unless the regulations under § 4960 provide clear guidance — through a safe harbor definition of “employee” or through allocation of the compensation paid to the employee based on the services he or she performs for the ATEO — there is a strong likelihood that ATEOs will have to expend additional resources to hire wholly independent officers, rather than relying on donated services from related for-profit entities that control, but are not controlled by, the ATEO.

This result is especially troubling with respect to the charitable sector because it would likely cause a significant diminution in the philanthropic activities of large and small for-profit entities, including many of the Fortune 500 companies that contribute funding, services, and in-kind resources to related § 501(c)(3) organizations. Many charitable organizations rely heavily on donations of this kind from for-profit entities to accomplish their charitable purposes. Adopting an interpretation of § 4960 that effectively imposes on charitable organizations the additional burdens of hiring and compensating service providers who, until now, have been provided without charge by related for-profit entities is the opposite of what Congress intended by enacting § 4960. There is no indication in the legislative history of § 4960 that the statute was intended to discourage for-profit entities from contributing services to charitable organizations or to deplete the resources that tax-exempt organizations could otherwise devote to their exempt functions.⁶

To prevent these negative consequences and instead encourage for-profit entities to continue to provide the services of their employees gratis to benefit related ATEOs, we suggest that the regulations adopt one of the rules discussed below, both of which are supported by the statutory language.

Detailed Comments

I. Safe Harbor Based on the Form 990 Volunteer Exception

Scope of the Safe Harbor, Under the first proposed set of rules, the Agencies would provide a safe harbor based on the existing exception from the requirement to report, on the Form 990, compensation paid to certain volunteers of tax-exempt entities (the “Volunteer Exception”). This exception has existed in the Form 990 instructions (the “Instructions”) since at least 2006, and thus represents the Agencies' long-standing and consistent policy in this area.

• Under the Volunteer Exception, the filing organization (i.e., the ATEO) need not report compensation paid by a related organization to a volunteer officer, director, or trustee of the filing organization if the related organization is a for-profit organization, is not owned or controlled directly or indirectly by the filing organization or one or more related tax-exempt organizations, and does not provide management services for a fee to the filing organization.⁷

• The new safe harbor would provide that (1) a volunteer who qualifies for the Volunteer Exception with respect to an ATEO will not be considered an “employee” of the ATEO for purposes of § 4960, and (2) no compensation paid by the for-profit entity to the volunteer will be taken into account for purposes of § 4960 with respect to the ATEO.⁸

The requirement to report compensation on the Form 990 is intended to discourage tax-exempt organizations from (1) paying excessive compensation to their directors, trustees, and officers, (2) violating the impermissible benefit rules, and (3) subsidizing a related taxable entity, by mandating detailed reporting of the compensation paid to directors, trustees, and officers and making the information publicly available. These goals mirror those that Congress had in mind when it enacted § 4960.⁹

The Volunteer Exception was adopted to relieve tax-exempt organizations from having to report compensation that is paid to their service providers by an entity that is not the filing organization (and is not controlled by the filing organization), based on the Agencies' judgment that reporting such compensation does not serve the purposes of the Form 990 reporting requirements. More specifically:

• The Volunteer Exception is intended to carve out from the Form 990 reporting requirement situations in which the tax-exempt organization is not expending its own resources but is instead receiving in-kind services from a for-profit entity gratis.

• As the Instructions recognize, compensation paid to directors, trustees, and officers of a tax-exempt organization by a related entity that is not controlled by the tax-exempt organization (and does not receive a management fee from the tax-exempt organization) does not raise the concerns that the Form 990 reporting requirement is designed to address — i.e., that a disproportionate amount of the tax-exempt organization's resources may be diverted from the organization's exempt activities to pay compensation expenses.

• The Instructions also recognize that the fact that the related entity may control the tax-exempt organization, within the meaning of § 512(b)(13)(D), does not make it more likely that a disproportionate amount of the tax-exempt organization's funding will be used for compensation. In fact, it makes it less likely because, as noted above, related entities often donate their employees' services to tax-exempt organizations that they control, in order to ensure that their donated funds, goods, and services are being used to further the tax-exempt organization's mission as efficiently as possible.

The same considerations that informed establishment of the Volunteer Exception in the Form 990 context support use of the Volunteer Exception to create a safe harbor in the § 4960 context. As noted above, it is not uncommon for a for-profit entity that establishes and provides significant funding to a tax-exempt organization to also provide volunteer directors and officers to oversee the use of the donated funds and to provide expertise and manpower to the tax-exempt organization. The IRS has recognized that (1) using volunteer directors and officers does not draw on the resources of the tax-exempt organization — and in fact helps to free up those resources for charitable or other tax-exempt activities, and (2) reporting compensation paid to these individuals by related organizations when the requirements of the Volunteer Exception are met does not serve to discourage the use of tax-exempt resources for inappropriate purposes. The IRS has therefore determined that such compensation need not be reported on the Form 990.

The same rationale applies under § 4960: Using volunteer officers and directors who are employed by a related for-profit entity to provide management, administrative, and other services to the ATEO means that the ATEO does not have to divert its resources to pay for these services. Thus, there is no reason to dissuade for-profit entities from contributing volunteer services at no cost to related ATEOs. And, of course, creation of a safe harbor that does not impinge on the purposes of § 4960 will provide greater certainty, uniformity, and fairness in administration of the excise tax.

Administrability. Because the safe harbor would be based on a determination already familiar to ATEOs and the Agencies, the safe harbor should not be difficult for ATEOs to use or for the Agencies to administer.¹⁰

Statutory Language. Adopting a safe harbor rule similar to the Volunteer Exception would be consistent with the language of § 4960:

• Section 4960 applies with respect to any “covered employee.”¹¹

• A “covered employee” is defined as “any employee (including any former employee) of an applicable tax-exempt organization” if the employee meets certain criteria.¹²

• The term “employee” is not defined in § 4960. Thus, Congress left it to the Agencies to define “employee” for § 4960 purposes.

• The Notice already recognizes that the term “employee” refers only to common law employees.¹³

• As noted above, individuals who are (1) employed by a related entity and (2) perform services for the tax-exempt organization as volunteers in connection with their employment by the related entity often are not common law employees of the tax-exempt organization and are common law employees of the related entity.

• As the Notice also recognizes, “the definition of related organization for purposes of section 4960 generally aligns with the definition of related organization for purposes of the annual reporting requirements on Form 990, reducing the burden on organizations in identifying related organizations, calculating compensation from related organizations, and determining liability under section 4960.¹⁴

• Thus, creating a safe harbor that provides that volunteers are not “employees” of the ATEO under § 4960 if the Form 990 criteria are satisfied is consistent with the reference to “employee” in the statute, the general definition of a common law employee,¹⁵ and the position taken in the Notice that the tax should apply only to compensation paid to common law employees of the tax-exempt organization.

• Creating such a safe harbor would also put tax-exempt organizations whose volunteer officers are employed by related entities in the same position as tax-exempt organizations that receive services from volunteer officers who are not employed by related entities. In both cases, § 4960 would not apply to services performed for the tax-exempt organization that are not paid for by the tax-exempt organization (or an entity that it controls) and therefore do not draw on resources that can be used for the organization's other tax-exempt activities.

Potential for Abuse. The Volunteer Exception is already designed to prevent abuse that might thwart the legislative intent of § 4960. In order to qualify for the Volunteer Exception —

• The applicable related organization must be a for-profit organization that is not owned or controlled directly or indirectly by the filing organization or any other related tax-exempt organization. This rule would prevent an ATEO from avoiding the excise tax through establishment of a for-profit subsidiary to pay its covered employees, or by shifting the obligation for payment to an existing for-profit subsidiary.

• The applicable related organization must not provide management services for a fee to the filing tax-exempt organization. This rule would prevent an ATEO from avoiding the excise tax by placing the obligation for payment of its employees on a related organization while continuing to bear the cost through a reimbursement arrangement. The rule ensures that the cost of the services of the volunteer are a charitable expenditure of the for-profit entity rather than a compensatory expenditure of the ATEO.

II. Allocation of Compensation

Scope of the Rule. As an alternative to the safe harbor described above, the Agencies would provide a rule that (1) permits allocation of the compensation paid by a for-profit entity between the tax-exempt organization and the for-profit entity, based on the services performed by the individual for each entity, and (2) applies § 4960 only to the compensation allocable to services performed as a common law employee of the tax-exempt entity.¹⁶ Such a rule would more precisely target the compensation that Congress was concerned about when it enacted § 4960.¹⁷ It would also prevent § 4960 from discouraging reasonable donations by for-profit entities of their employees' services to related tax-exempt organizations, thus preserving tax-exempt resources and furthering Congress's goal of maximizing the use of finite resources to further exempt activities.

Section 4960 and the Notice already provide a framework for allocating compensation for other purposes, namely for determining how much compensation paid to a licensed medical professional is attributable to the performance of medical services.¹⁸ Similar rules could apply in allocating compensation to services performed for an ATEO on the one hand and for related organizations on the other. For example, the rule could require the taxpayer to use the allocation of compensation set forth in an employment agreement or other written arrangement unless the facts and circumstances demonstrate that the allocation is unreasonable or was established for purposes of avoiding application of the excise tax under § 4960.¹⁹

Administrability. The Form 990 currently requires an ATEO to separately determine the average number of hours per week that its officers, directors, trustees, key employees, and highest compensated employees devote to (1) the ATEO, and (2) the ATEO's related organizations, even if the ATEO is not required to report the individual's compensation under the Volunteer Exception.²⁰ Therefore, many ATEOs are already well-equipped to determine how their service providers' hours of service are spent. Rules for allocating a volunteer's compensation could utilize a presumption that compensation is allocable to each related service recipient in proportion to the average hours per week that the volunteer devotes to such service recipient.²¹

Statutory Language. Adopting an allocation rule would be consistent with the language of § 4960.

• Section 4960(a)(1) provides that § 4960 applies to, inter alia, “remuneration paid . . . by an applicable tax-exempt organization for the taxable year with respect to employment of any covered employee in excess of $1,000,000.”²²

• Section 4960(c)(4) states that “[r]enumeration of a covered employee by an applicable tax-exempt organization shall include any remuneration paid with respect to employment of such employee by any related person or governmental entity.”²³

• The phrase “by any related person or governmental entity” in § 4960(c)(4) refers to remuneration paid to the employee, and the phrase “with respect to employment of such employee” is reasonably understood to refer back to the almost identical phrase in § 4960(a)(1), which uses the same term to refer to employment of the employee by the tax-exempt organization.

• The Agencies have already determined that a person must be a common law employee of an ATEO to become a covered employee of the ATEO. Thus, these two provisions can be read together to impose the excise tax only on the portion of an employee's compensation that is paid in exchange for services performed as a common law employee of the ATEO.

• This understanding of the statute is consistent with the purpose of § 4960 — taxing excess compensation paid by tax-exempt organizations or related organizations for services performed as a common law employee of a tax-exempt organization.

Potential for Abuse. To preclude abusive allocation arrangements designed to avoid applying § 4960 to compensation that draws directly or indirectly on an ATEO's resources, the regulations could require that the allocation rule apply only if (1) the for-profit organization is not owned or controlled directly or indirectly by the filing tax-exempt organization or any other related tax-exempt organization, (2) the for-profit organization does not provide management services for a fee to the filing tax-exempt organization, and the tax-exempt organization does not otherwise reimburse the for-profit organization for the compensation paid by the for-profit organization (or otherwise compensate the individual), and (3) the individual provides a greater proportion of services in the year in question to his or her for-profit employer than to the related ATEO.

Respectfully submitted,

Julie M. Edmond
Covington & Burling LLP
Washington, DC